Inverse ETF: A Contrarian Exchange Traded Fund

I've thought about the idea of an inverse exchange traded fund (ETF) on occasion. The idea is that this ETF would move inversely to some index so that when an index goes down, the ETF would go up. For those that like to bet against the market, such ETFs might seem like the perfect contrarian investment tool.

Something about this idea bothered me, but until today I didn't know what it was. Sure an inverse ETF could probably be constructed to actually perform as promised, but if you're a buy and hold investor, does it make sense? Or to put it another way, if you had the ability to determine with certainty that an index would go down, you would effectively know when to get in and out of a market. And there's no one out there that can do that.

You'll have a better chance of a success if you follow the idea behind a diversified portfolio which is to assemble holdings that are uncorrelated, but trend upward in the long-run. The uncorrelated feature is key as it is what reduces volatility which in turn can prevent panic-selling. And the long-term upward trend is also key since you want your portfolio, in its entirety, to grow over time.

Adding an inverse ETF to your portfolio would be counter-productive. By its nature, such an ETF would simply move in the opposite direction of an index. So if you held equal amounts of an index ETF and an inverse ETF for that index, you would make no money whatsoever. Seems kind of pointless, doesn't it? Morningstar even goes so far as to call these sucker bets.

And with that I get to toss the inverse ETF idea. And I'm glad I didn't find a way to waste money on such a product.

The ETF guy seems to miss the point on the use of the inverse ETF. It's a form of insurance or a hedge for the occassional storms that assault ones long term portfolio. By definition, this is a short term (less than a year exercise). Most of us are long term, buy or long side investors. We buy equities or bonds for income or because we believe they will go up in value. Most of us can live with an 8 - 10% return. When things go done in value, we trim positions to wait out the storm. Since holding cash rarely makes us money, doesn't it make sense to capitalize on the down moves as well as the up ones? Year to date the S&P 500 is down some 8%. The poor fundamentals for the financial sector (20% of the market) and the impact of energy and commodity costs on profits haven't been fully reflected yet in the markets. There's still too much optimism out there. We need more fear. What an excellent time for the inverse ETF, at least to October.

Woody's comments are accurate. take a look at FAS and FAZ in the US NYSE and you'll see what can be done for trade balancing. these are true inverse/mirror ETF's. If you have the nerve for it, you can swing -trade them all day long - never a bad day in the market !!

I would prefer to find non-short etfs which move in opposite directions, where I could invest in both simultaneously, and
just profit in small amounts from the difference,but I do not
know what they would be. It seems relationships are always
mutating in an economy where the currency is not stable and
the future cost of energy is anyone's guess. You do know some
things, like no one is going to be buying clothing when gas
prices move up, or restaurant eating will falter when food prices
rise, but it is hard to link etfs up which tend to move in opposite
directions to a less degree than those which just short.

An ETF and its Inverse are completely anti-correlated, which means as one goes up, the other goes down. If you always sell the one that is higher, and buy the one that is lower, you'll always be selling high, and buying low. That is the whole point of Modern Portfolio Theory.

Inverse ETFs can also be good for insurance. Suppose you were graduating in a year's time and you are worried about the possibility you will enter the job market during a recession. You can hedge against that loss by buying inverse ETFs.

Inverse ETFs are very useful tools for finance professionals, particularly on the buy side firms, who have severe restrictions on their personal trading imposed by their firms. Most commonly they could include (like in my case) (a) a minimum holding period of 90 days (b) NO short-selling.

Now suppose for example, you happen to invest in an index ETF and 10 days later you realized that the top has happened. You can't get out due to personal trading restrictions. What could you do ? You need to hold that ETF for another 90-10=80 days and you can't take a fresh short position either.

While it's true that simply negating another investment is counter-productive, this is not the role of shorting.

Often, portfolios are almost fully invested and deciding to pull the plug and sell may trigger large capital gains.

A short in a specific sector may take the edge off the risk of a larger composite index.

For example, The Canadian index (S&P/TSX) contains large portions of energy and mining stocks as well as financials. If an investor decides that the energy portion of the index is getting to risky he can short an energy position to offset some of that risk, while keeping the overall composite index.

Thus, if the index had been held for a few years, holding on to it does not trigger a massive taxable capital gain.

Any shortfall attributable to the energy sector would be somewhat offset by the rise of the energy shorts. As a bonus, should the investor be long term bullish on energy, the extra earnings on the shorts could be reinvested at a lower buying price.

So, short ETFs are decent tools to offset sectors that appear to be weakening, without having to resort to a wholesale cashing out of a portfolio. It thus gives some extra breathing room in cash and time to decide one's long term asset allocation, especially when the direction of the markets seem uncertain.